Lecture 1

Common macroeconomic indicators and stylised facts Going deeper: the components of real GDP Keynesian multiplier and the IS curve

Macroeconomic CSI: the economic crisis andthe goods market

Rodolphe Desbordes

http://www.rodolphedesbordes.com/

http://www.rodolphedesbordes.com/


Table of Contents I

1 Common macroeconomic indicators and stylised facts

2 Going deeper: the components of real GDP

3 Keynesian multiplier and the IS curve


The three most important economic indicators

These three indicators provide us with a broad picture of the “crime scene”:

1 Real GDP: the principal measure of material well-being and economicproductivity.

2 Unemployment rate: the principal measure of how far production isfalling short of potential output; a measure of the relative distribution ofeconomic well-being.

3 Inflation rate: the principal measure of economic stability.


Real GDP growth rate in developed and developingcountries

−5

0

5

10

%

2000 2002 2004 2006 2008 2010Year

Advanced economies Emerging and developing economies

Source: http://www.imf.org/external/datamapper/index.php

1 We can observe that the economic crisis started at the end of 2007.2 Both developed and developing economies have been hit by the

economic crisis, suggesting a common crisis factor and/or internationalcontagion.

3 Developed countries went into recession, as their output contracted.However, in developing countries, we cannot talk about a recessionsince the growth rate of output remained positive.

http://www.imf.org/external/datamapper/index.php


Real GDP growth rate in the U.S. and the U.K.

−5

0

5

10

%

1980 1990 2000 2010Year

United Kingdom United States


1 We can observe the occurrence of business cycles in both countries.There is a short-run alternation between recessions and expansions.

2 Compared to previous recessions, the current recession is very severe,at least in terms of output contraction.

3 In 2009, the fall in output was greater in the U.K. than in the U.S.



Unemployment rate in the U.S. and in the U.K.

4

6

8

10

%

2003q1 2004q3 2006q1 2007q3 2009q1 2010q3Quarter



1 Given that output has contracted, unemployment has risen.2 In other words, we observe Okun’s Law: unemployment rises when the

growth rate of real GDP falls.3 Curiously, even though the fall in output has been higher in the U.K.

than in the U.S., the rise in unemployment has been higher in the latter.



Inflation rate in the U.S. and in the U.K.

0

1

2

3

4

%

2000 2002 2004 2006 2008 2010Year



1 Inflation rose in both countries until the onset of the crisis and thendeclined.

2 The inflationary trajectories of both countries have not been identical.3 Inflation remained relatively high in the U.K. but the U.S. economy

experienced deflation (a fall in the average price level) in 2009.



Aggregate output and total spending

Aggregate output (GDP) is the market value of the final goods and servicesproduced in an economy over a certain period. It is equal by definition to totalactual spending/expenditures (AE) on domestically produced final goods andservices.

In equilibrium, Aggregate Demand (AD), i.e. the sum of all planned or vol-untary spending on domestically produced goods and services, must also beequal to income and production Y = AD. The difference between AD and AEis the change in inventories, i.e. the addition to the stocks of goods held tosatisfy future sales.

To understand the economic crisis, we need to look at the behaviour of thedifferent components of total expenditures on goods and services:

1 C: Consumption.2 I: Investment.3 G: Government purchases.4 NX: net exports, i.e. Exports (X) - Imports (M).


Growth rates of the components of U.S. real GDP

−40

−20

0

20

40

%

1950 1960 1970 1980 1990 2000 2010year

Gr_C Gr_G Gr_I

Source: http://www.bea.gov/national/nipaweb/SelectTable.asp?Popular=Y

1 We can observe that fluctuations of I dwarf the fluctuations of the othercomponents.

2 Investment spending often seems to drive the business cycle. Inrecessions, investment spending decreases a lot and in expansions,investment spending increases a lot.

3 Note that the driver (6= cause) of a recession is not necessarily thecomponent with the largest share in GDP ( I

GDP =15% in the U.S.). It isthe most volatile.

http://www.bea.gov/national/nipaweb/SelectTable.asp?Popular=Y


Dissecting U.S. Investment

Investment can be divided into four components:

1 Non-residential buildings: the purchase of buildings and infrastructureby firms.

2 Durable equipment: the purchase of machines and software.3 Residential building: the purchase of new housing by households and

landlords.4 Change in inventories: when production is not sold, it is added to firms’

inventories of goods. Firms also hold inventories to satisfy unexpectedconsumer demand quickly.


The growth rates of the components of investment

−30

−20

−10

0

10

%

1996 1998 2000 2002 2004 2006 2008 2010Year

G_residential G_nonresidential G_equipmentandsoftware


1 All components have seen their values slumped since the start of theeconomic crisis.

2 However, the fall in residential investment started much earlier than forthe other components.

3 Declines in spending on homes seem to have played a significant rolein the economic crisis (at least in the U.S.).



Inventories and economic uncertainty

−100

−50

0

50

100

$ US billi

ons

1995 2000 2005 2010Year


1 By definition, production is the sum of sales and change in inventories.2 The negative change in inventories mean that sales have not been met

by current production but past production.Firms are likely to be uncertain regarding future growth prospects of theU.S. economy.



Aggregate effects of a fall in investment

We have seen that investment can be very volatile. BUT overall it is only1/6 of total GDP.

Hence, how can we explain that changes in this relatively smallcomponent can have a big influence on the rest of the economy?

Well, that can happen if a feedback loop occurs between income andaggregate demand, i.e. a fall in aggregate demand resulting from anegative investment shock induces a fall in income which induces a fallin aggregate demand... until a new equilibrium is eventually reached.

Indeed Keynes wrote in 1936

It is, however, to the general principle of the multiplier towhich we have to look for an explanation of how fluctuationsin the amount of investment, which are a comparatively smallproportion of the national income, are capable of generatingfluctuations in aggregate employment and income so muchgreater in amplitude than themselves.


The source of the multiplier effect

A multiplier effect occurs when the long-run effect of a change is greaterthan the initial shock.

Such an effect can occur only if there is a feedback loop between thecomponents of AD and Y .

We therefore need to look for determinants of AD related to Y .

Two obvious candidates are Consumption and Investment.


The determinants of C and IConsumption is made of

1 an autonomous/baseline component influenced by factors such ashousehold total stock market and real estate wealth: Co;

2 the part c (0 < c < 1) of the after-tax (1− t) income Y that you do notsave: c(1-t)Y

C = Co + c(1− t)Y

Investment is made of1 an autonomous/baseline component influenced by factors such as

expected future profits: AI ;2 a component negatively related to the interest rate r , i.e. the cost of

borrowing (or the opportunity cost of lending) ar ;3 a component positively related to income Y as cash flow (current profit)

determines their ability to finance investment through internal funds.

I = AI − ar + b1Y


The size of the multiplier

We know that Y = C + I + G in a closed economy. We can replace C and Iby their two linear functions:

Y = C + I + G

Y = Co + c(1− t)Y + AI − ar + b1Y + G

Y = (Co + AI + G)− ar + (c(1− t) + b1)Y

Y (1− (c(1− t)− b1)) = (Co + A + G)− ar

Y (s + ct − b1)) = (Co + AI + G)− ar

Y =1

(s + ct − b1)︸︷︷︸[(Co + AI + G)− ar ]

Multiplier

Note that we call c, the marginal propensity to consume and (1− c) = s is themarginal propensity to save. The size depends on the feedback loop betweenAD and Y : (c(1− t) + b1). The greater it is, the bigger the multiplier is.


A graphical interpretation of the multiplier

Init

iali

ncr

ease

inI

E ect on Y

Demand, Production Y

Income YY1 Y2

45 degrees

A

B

AD1

AD2

Y1 Y2

We know that production is always equal to income and toactual expenditures (Y = AE), corresponding to points ona 45 degrees line.

We know that AD is also equal in equilibrium to Y = AE .AD can be expressed as a function of income, since someof its components depend on current income.

1 Direct effect: If I ↑ (increases by) £1 billion, AD ↑ £1 billionand production Y ↑ by £1 billion;

2 Feedback effect 1a: If Y ↑ £1 billion, C ↑ c(1− t) billionand I ↑ by b1 billion ;

3 Feedback effect 1b: Y ↑ c(1− t) + b1 billion ;4 Feedback effect 2a: If Y ↑ c(1− t) + b1 billion, C ↑

c(1− t)[c(1− t) + b1] billion and I ↑ by b1[c(1− t) + b1]billion

5 Feedback effect 2b: Y ↑ [c(1− t) + b1]2 billion...

6 Successive rounds occur until the increase in Y is equalto the multiplier 1

(s+ct−b1).

With s = 0.4, t = 0.3 and b1 = 0.1, you find that income increases by £2.03 billions.


Investment and macroeconomic policy

Look again at the investment function

I = AI − ar + b1Y

You can see the term ar , saying that investment is negatively related tothe level of the interest rate r .

Changes in r will have a strong effect on AD through the multipliereffect.

r is (mostly) controlled by the Central Bank.

An interest rate targeting central bank can then stimulate the economyby cutting interest rates and contract the economy by raising interestrates.


Stabilisation policy

Look again at AD

Y =1

(s + ct − b1)︸︷︷︸[(Co + A + G)− ar ]

Multiplier

You can see that in addition to an active monetary policy, a government hasother options to stabilise the economy, i.e. to smooth out the business cycle:

1 It can increase government spending G2 It can decrease taxes t3 It can try to influence expectations, captured by Co and A


The IS curve

We know that

Y = C + I + G

I = Y − C −G

I = (Y − T − C)︸︷︷︸+(T −G)︸︷︷︸I = Private S Gvt S

So the IS (Investment-Savings) curve is the curve showing when I = S, whichis equivalent to saying that points on this curve satisfy the goods market equi-librium Y = AD.

The IS curve is downward sloping when plotted against the interest rate be-cause of the negative relationship between I and r .


Deriving the IS curve

Source: Carlin Wendy and Soskice David (2006). Macroeconomics. Oxford: OUP Press.


Fiscal stimulus as a % of GDP in 2008

−10 −5 0 5

United StatesUnited Kingdom

SwitzerlandSweden

SpainSlovak

PortugalPolandNorway

New ZelandNetherlands

MexicoLuxembourg

KoreaJapan

ItalyIrelandIceland

HungaryGermany

FranceFinland

DenmarkCzech

CanadaBelgiumAustria

Australia

Source:OECD. http://www.oecd.org/dataoecd/3/62/42421337.pdf

http://www.oecd.org/dataoecd/3/62/42421337.pdf


Short-term interest rates, per annum

0

2

4

6

8

%

1996 1998 2000 2002 2004 2006 2008 2010Year

United Kingdom United States Euro area

Source:OECD. http://www.oecd.org/document/61/0,3343,en_2649_34573_2483901_1_1_1_1,00.html

http://www.oecd.org/document/61/0,3343,en_2649_34573_2483901_1_1_1_1,00.html


Taking stock. Please answer the following questions:

1 What have you learnt today?

2 What have you understood the best?

3 What have you understood the least?

4 Did you enjoy the lecture? Explain why.

5 Please grade the lecture on a 0-100 scale (poor to excellent).

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Lecture 1

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